Profitability ratios

Profitability ratios: What is it?

Profitability ratios measure a company’s ability to generate earnings relative to sales, assets and equity. These ratios assess the ability of a company to generate earnings, profits and cash flows relative to relative to some metric, often the amount of money invested. They highlight how effectively the profitability of a company is being managed.

Common examples of profitability ratios include return on sales, return on investment, return on equity, return on capital employed (ROCE), cash return on capital invested (CROCI), gross profit margin and net profit margin. All of these ratios indicate how well a company is performing at generating profits or revenues relative to a certain metric.

Different profitability ratios provide different useful insights into the financial health and performance of a company. For example, gross profit and net profit ratios tell how well the company is managing its expenses. Return on capital employed (ROCE) tells how well the company is using capital employed to generate returns. Return on investment tells whether the company is generating enough profits for its shareholders.

For most of these ratios, a higher value is desirable. A higher value means that the company is doing well and it is good at generating profits, revenues and cash flows. Profitability ratios are of little value in isolation. They give meaningful information only when they are analyzed in comparison to competitors or compared to the ratios in previous periods. Therefore, trend analysis and industry analysis is required to draw meaningful conclusions about the profitability of a company.

Some background knowledge of the nature of business of a company is necessary when analyzing profitability ratios. For example sales of some businesses are seasonal and they experience seasonality in their operations. The retail industry is example of such businesses. The revenues of retail industry are usually very high in the fourth quarter due to Christmas. Therefore, it will not be useful to compare the profitability ratios of this quarter with the profitability ratios of earlier quarters. For meaningful conclusions, the profitability ratios of this quarter should be compared to the profitability ratios of similar quarters in the previous years.  


Cash Return on Capital Invested (CROCI)

Cash return on capital invested (CROCI) is metric that compares the cash generated by a company to its equity. It is also sometimes known as “cash return on cash invested”. It compares the cash earned with the money invested.

DuPont Formula

DuPont formula (also known as the DuPont analysis, DuPont Model, DuPont equation or the DuPont method) is a method for assessing a company's return on equity (ROE) breaking its into three parts.

Earnings Before Interest After Taxes (EBIAT)

Earnings Before Interest and After Taxes is used to measure the ability of a firm to generate income through various operations during a specific course of time.

Earnings Retention Ratio

Earning Retention Ratio is also called as Plowback Ratio. As per definition, Earning Retention Ratio or Plowback Ratio is the ratio that measures the amount of earnings retained after dividends have been paid out to the shareholders. 

EBIT (Earnings Before Interest and Taxes)

EBIT (Earnings Before Interest and Taxes) is a measure of a entity's profitability that excludes interest and income tax expenses. 

EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is an indicator of a company's financial performance. It measures a company’s financial performance by computing earnings from core business operations, without including the effects of capital structure, tax rates and depreciation policies.

EBITDARM

Short for Earnings before Interest, Taxes, Depreciation, Amortization, Rent and Management fees, EBITDARM refers to a financial performance measure which is used in comparison to more common measures like EBITDA in situations where the rent and management fees of a company represent a larger-than-normal percentage of operating costs.

EBT (Earnings Before Tax)

Earnings before taxes (EBT) can be defined as the money retained by a company before deducting the money due to be paid as taxes. 

Effective Rate of Return

The effective rate of return is the rate of interest on an investment annually when compounding occurs more than once.

Gross Profit Margin

Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of sales) to sales revenue. It is the percentage by which gross profits exceed production costs. Gross margins reveal how much a company earns taking into consideration the costs that it incurs for producing its products or services.

Net Interest Margin

The net Interest margin can be expressed as a performance metric that examines the success of a firm’s investment decisions as contrasted to its debt situations. A negative Net Interest Margin indicates that the firm was unable to make an optimal decision, as interest expenses were higher than the amount of returns produced by investments. Thus, in calculating the Net Interest Margin, financial stability is a constant concern.

Net Profit Margin

Net profit margin (or profit margin, net margin) is a ratio of profitability calculated as after-tax net income (net profits) divided by sales (revenue). Net profit margin is displayed as a percentage. It shows the amount of each sales dollar left over after all expenses have been paid.

NOPLAT (Net Operating Profit Less Adjusted Taxes)

NOPLAT is Net Operating Profit Less Adjusted Taxes. It is a measurement of profit which includes the costs and the tax benefits of debt financing. In other words, it can be said that NOPLAT is the earnings before interest and taxes after making the adjustments for taxes. It is a firm’s total operating profit where adjustments for taxes are made. It shows the profits that are generated from the core operations of a company after making the deductions of income taxes which are related to the company’s core operations. For the creation of DCF models or the discounted cash flow models, often NOPLAT is used.

OIBDA

OIBDA (operating income before depreciation and amortization) is a non Generally Accepted Accounting Principle related measurement of finance based performance utilized by entities to display profitability in continuing business related activities that does not take into consideration the effects of tax based structure and capitalization. 

Operating Expense Ratio

Operating expense ratio can be explained as a way of quantifying the cost of operating a piece of property compared to the income brought in by that property. 

Operating Margin

Operating margin (operating income marginreturn on sales) is the ratio of operating income divided by net sales (revenue).

Overhead Ratio

Overhead ratio is the comparison of operating expenses and the total income which is not related to the production of goods and service. The operating expenses of a company are the expenses incurred by the company on a daily basis. The operating expenses include maintenance of machinery, advertising expenses, depreciation of plant, furniture and various other expenses. These expenses when controlled can provide a company by maintaining the quality of the business. All companies want to minimise overhead expenses so that it helps them understand and manage the revenues of the company.

Profit Analysis

In managerial economics, profit analysis is a form of cost accounting used for elementary instruction and short run decisions. A profit analysis widens the use of info provided by breakeven analysis. An important part of profit analysis is the point where total revenues and total costs are equal. At this breakeven point, the company does not experience any income or any loss.

Profitability Index

Relative Return

Relative return refers to the return achieved by an asset over a specific time period contrasted to a benchmark. The relative return is computed as the difference between the absolute return reached by the asset and the return reached by the benchmark.

Return On Assets (ROA)

Return on assets (ROA) is a financial ratio that shows the percentage of profit that a company earns in relation to its overall resources (total assets).Return on assets is a key profitability ratio which measures the amount of profit made by a company per dollar of its assets. It shows the company's ability to generate profits before leverage, rather than by using leverage.

Return on Average Assets (ROAA)

Return on Average Assets (ROAA) can be defined as an indicator used to evaluate the profitability of the assets of a firm. Putting it simple, this return on average assets indicates what a company can do with what it possesses. Generally, it is used by companies, banks and other financial institutions as an appraisal for determining their performance.

Return on Average Capital Employed (ROACE)

The return on average capital employed (ROACE) is a ratio that reveals the profitability against the investments made in the company. The ROACE is different from the return on capital employed for it counts the average of the opening and closing capital for the specific period contrasting to only the capital figure at the end of a period.

Return on Average Equity (ROAE)

The return on average equity (ROAE) refers to the performance of a company over a financial year. This ratio is an adjusted version of the return of equity that measures the profitability of a company. The return on average equity, therefore, involves the denominator being computed as the summation of the equity value at the beginning and the closing of a year, divided by two.

Return On Capital Employed (ROCE)

Return on capital employed (ROCE) is a measure of the returns that a business is achieving from the capital employed, usually expressed in percentage terms. Capital employed equals a company's Equity plus Non-current liabilities (or Total Assets − Current Liabilities), in other words all the long-term funds used by the company. ROCE indicates the efficiency and profitability of a company's capital investments.

Return on Debt (ROD)

The return on debt (ROD) can be expressed as the quantification of a company’s performance or net income as allied to the amount of debt issued by the company. Putting it other way, the return on debt refers to the amount of profit generated for every dollar held by a company in debt. 

Return On Equity (ROE)

Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet.

Return On Invested Capital (ROIC)

ROIC is the capital which is return on investment in business is a high-tech way of examining a stock at return on investment that corrects for some specialties of Return on Assets and Return on Equity.

Return on Investment (ROI)

Return on investment (ROI) is performance measure used to evaluate the efficiency of investment. It compares the magnitude and timing of gains from investment directly to the magnitude and timing of investment costs. It is one of most commonly used approaches for evaluating the financial consequences of business investments, decisions, or actions.

Return on Net Assets (RONA)

The return on net assets (RONA) is a comparison of net income with the net assets. This is a metric of financial performance of a company that takes into account earnings of a company with regard to fixed assets and net working capital.

Return on Research Capital (RORC)

The return on research capital (RORC) is a calculation used to assess the revenue earned by a company as an outcome of expenditures made on research and development activities. The return on research capital is an element of productivity and growth, as research and development is one of the techniques employed by the companies to develop new products and services for sale. This metric is generally used in industries that depend largely on R&D like the pharmaceutical industry.

Return on Retained Earnings (RORE)

The return on retained earnings (RORE) is a calculation to reveal the extent to which the previous year profits were reinvested. The return on retained earnings is expressed as a percentage ratio. A higher return on retained earnings indicates that a company would be better off reinvesting the business. On the contrary, a lower return on retained earnings indicates that paying out dividends might prove to be in the company’s best interests.

Return on Revenue (ROR)

The return on revenue (ROR) is a measure of profitability that compares net income of a company to its revenue. This is a financial tool used to measure the profitability performance of a company. Also called net profit margin.

Return On Sales (ROS)

Return on sales (ROS) is a ratio widely used to evaluate an entity's operating performance. It is also known as "operating profit margin" or "operating margin". ROS indicates how much profit an entity makes after paying for variable costs of production such as wages, raw materials, etc. (but before interest and tax). It is the return achieved from standard operations and does not include unique or one off transactions. ROS is usually expressed as a percentage of sales (revenue).

Revenue per Employee

Revenue per employee measures the amount of sales generated by one employee. This is a measure of performance of human resources of a company. It is an indicator of productivity of company’s personnel. It also indicates how efficiently a company is utilizing its human resources.

Risk-Adjusted Return

It is a concept which measures the value of risk involved in an investment’s return. It is of great importance because it enables the investors to make comparison between performance of a high risk, high risk investment return with less risky and lower investment returns. Risk adjusted return can apply to investment funds, portfolio and to individual securities.

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